Penny: So Rich, should I use my IRA to pay a chunk of my $173,000 in student loans?
Rich: Hey Pen, I didn’t realize your house payment was so low compared to local rents … I said sell the house, but that changes the equation. How much is in your IRA?
Penny: I have around $35,000 in mine and my husband has $7,000 in his (he already cashed most of his out when starting his business).
Rich: Ah, I see. So you have around $42,000 remaining. At some point I’d love to hear more about the business — how it’s going, if there’s extra business debt, etc.
Penny: Sure, cuz. Now focus! Student loans. Let’s say we cash in $30,000 from our IRAs and put it toward our student loans. Am I doing the math right here… $30,000 x 6.375% = $1,912.50 per year saved in interest payments x 13 years = does that actually equal a savings of $24,862.50 if we weren’t paying interest on that amount the remainder of the time?
Rich: Well, under your current plan you will pay off the loan in 13 years and pay $86,000 in interest. A very rough spreadsheet (working off one of your old ones) shows that if you took $30,000 to pay principal on the loan this year, it’d look like this:
So you’d save $29K I’m assuming that after you pay the big chunk, you’d stick with your annual $20K payment. What do you think?
I should mention that the way we are calculating this is not exactly correct. The reason is that student loan interest is usually not calculated annually. It accrues daily. Check out this article from Student Loan Hero about how student loan interest works.
Anyway, we’re not talking a huge difference, but it’ll be very difficult for us to get an amateur spreadsheet to match what’s actually going on in your loan statements. We aren’t math gurus.
Penny: Ok, cool beans. That’s fine. If I cared about math I probably wouldn’t be in all this debt. Ha! So do you think we should cash them out entirely, or leave a couple thousand in there just so we don’t close our accounts (that’s what I’m leaning toward doing).
Rich: Can you give me more detail on the contributions and earnings? The contributions can be withdrawn without penalty from a Roth IRA, but the earnings would be taxable and probably face a 10% penalty. Here’s a good article explaining Roth IRA withdrawal rules.
Penny: Sure. Out of my $35,000 IRA, if I’m looking at it correctly, I think my contributions were $20,000… so $15,000 would be earnings.
Rich: Hey, that’s pretty good! Way to stick with it through the Great Recession!
If it were me, I’d withdraw those contributions. Some people would say you shouldn’t do this because your IRA will grow faster than your debt (i.e. your investments will do better than 6.375%). Maybe, but maybe not. So how do we account for uncertainty?
What people miss, in my opinion, is the calculation of risk. Right now the stock market is at all-time highs. Many would say (and I would agree) that stocks are due for a dip.
On the other hand, if you pay off debt, you are guaranteed a return of 6.375% for the life of the loan. Look at it this way: If there was a risk-free savings account paying 6.375%, most people would be thrilled and shove buckets of money in there. Or look at it another way: Would you borrow money at 6.375% to invest in the stock market? No way.
So, your choice is between a risky 8% return or a risk free 6.375%. Considering this would knock a couple years off your loan, I say pay the debt. That said, I agree on leaving the earnings in to avoid the 10% penalty and keep the account open.
Penny: So, you would recommend just taking my contributions of $20,000 out? If we do that, we won’t get the 10% penalty? I don’t fully understand how that money is separated out (the contributions vs the earnings). So, I will still have $15,000 in the account, and since I will no longer have any contributions in there, it will all just be earnings? If I ever withdraw that money in the future, it will just be all earnings? How does Vanguard keep track of that all?
Rich: Yes, that’s what I’d recommend, take the contributions. Technically, you should keep track. Is it on a statement? When you withdraw it may ask you on the withdrawal form.
Later, before next year’s taxes, you’ll get a form 1099R that should confirm your withdrawal. Keep that for your accountant. It “proves” you withdrew contributions that will not be taxed. All of this is self-reporting so it’s not too tough. Considering your situation, you are not going to get audited by the IRS.
I guess my thinking about leaving the $15k in would be to avoid the penalty because you would not only pay a penalty (10%) you would also pay taxes on the gains, so you’d lose a chunk of that money.
Penny: Okay, that’s what I’ll do.
….. Time passes ….
Penny: Guess what? I called Vanguard today to withdraw our contributions (turned out to be $19,000)!
Rich: So, if you pay that toward the loan this year, and keep paying your $20K annually, you just saved yourself nearly $20K in interest. And your loan will be paid off 2 years earlier. Boom!
Readers, are these cousins crazy, or crazy like foxes? Are there better ways for Penny to pay off $173,000 with an income of $40,000? Under what circumstances would you sell assets to pay off debt?